Taxing Income from Illegal Activities: What the Courts have said

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By Lydia Nankabirwa,

Technical Officer – Public Financial Management and Tax

It is a cold morning. My colleagues and I are rushing to an economics symposium. Driving through one of the streets patronized by curb crawlers, we notice a policeman attempting to arrest a group of sex workers.

Whereas one would pick interest in the growing immorality as darkness falls on a number of streets of Uganda’s major towns, our concern was the economic impact that such activities have on the economy. In a number of economies, prostitution is a tax contributor and thus seemingly contributes some sums of money to the national Gross Domestic Product (GDP).

For the financial year 2019/20, the Government has unveiled a Uganda Shilling (UGX) 40 Trillion or United States Dollars (USD) 10.7 Billion budget with a projected domestic revenue collection (from tax and non tax revenues) at a tune of UGX 21 Trillion. The country’s tax base is considered by many to be narrow and any effort by the government to widen the tax base is instead perceived as a move to deepen the tax base. In Uganda there is no clear trace of how prostitution or any illegal activity could be taxed. One would then wonder whether, as a general principle, taxes should be levied on an illegal activity or transaction. To appreciate this better, we need to analyse a number of tax law concepts and similar jurisdictional experiences.

Lord McNaghten defined income tax as a tax on income irrespective of other considerations, notably, legality. “Whether one has fixed property or lives by his wits he contributes to the tax if his income is above the prescribed limit.”[1] Section 4(1) of the Income Tax Act (ITA) of Uganda states that: “Subject to, and in accordance with this Act, a tax to be known as income tax shall be charged for each year of income and is imposed on every person who has chargeable income for the year of income”.  Section 15 defines chargeable income of a person for a year of income as the gross income of the person for the year less total deductions allowed under the Act for the year, while according to Section 17 gross income includes the total amount of business income; employment income; and property income.

From the above provisions, for income tax to be levied, there has to be chargeable income derived from all geographical sources for resident persons or from sources within Uganda, for non-residents. The question as to what constitutes chargeable income can further be viewed from the perspective of legality and illegality of the income in question or the source of the said chargeable income.  

In Pickford v Quirke[2], court noted that the repeated nature of transactions is key in ascertaining whether the amount in question is liable to income tax or not.  While in Rutkin v. United States,[3] court noted that an unlawful gain, as well as a lawful one, constitutes taxable income when its recipient has such control over it that, as a practical matter, he derives readily realizable economic value from it. That occurs when cash is delivered by its owner to the taxpayer in a manner which allows the recipient freedom to dispose of it at will, even though it may have been obtained by fraud and his freedom to use it may be claimed by someone with a better title to it. The above precedents simply allude to two guiding principles on chargeability of income, that is, whether the activity that one is involved in is repetitive, and whether the person has control over the proceeds from such transactions.

Courts in neighboring Kenya have not had a divergent view on taxation of income from an illegal activity.  In Republic v Kenya Revenue Authority ex parte Yaya Towers Limited,[4] the Kenya Revenue Authority (KRA) sought to have an employee of the applicant remit his income tax, the court found the employee’s employment contract to be illegal. Whereas the High Court held that the KRA could not use an illegal relationship to assess tax as that would be contrary to public policy, on appeal, the above decision was overturned when the court held that;whether a business is illegal or services obtained were rendered by an illegal entity, it is still subject to tax for two reasons; firstly, holding otherwise would entitle a wrongdoer to benefit from illegal profits earned from unlawful business and, on top of that, be exempted from taxation. It would be an absurdity to tax the gains of an honest man while the dishonest escape taxation.  Secondly, if profits of an illegal business were not taxable, honest taxpayers would be incentivised to taint their businesses with an illegality for purposes of securing exemption from taxation.”

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